Out of the shadows: China’s financial problems have international implications


There can’t be too many people in Australia by now who don’t recognise how important China is to our collective economic future. The most immediately visible sign of this growing interdependence is the resource trade. The recent boom and the all-too-predictable bust in this country were almost entirely attributable to Chinese demand, which turned out to be slightly less insatiable than many thought.

We may have become accustomed to the idea that developments in the ‘real’ economy in China may have direct implications for Australia. What is less widely recognised is that China’s burgeoning, increasingly privatised, financial sector also has the capacity to influence economic outcomes here, despite having fewer direct connections.

Trying to make sense of what is happening in China is especially difficult for a couple of reasons. First, economic activity, policy and reporting are far from transparent. Second, there has never been an economy quite like China’s before in history. Not only is it well on the way to becoming the world’s biggest in remarkably short order, but it is organised in a way that is unlike anything in the West. This is, after all, the People’s Republic of China, and the Chinese Communist Party retains—or wants to retain—significant control over what used to be called the ‘commanding heights’ of the economy.

The question is, can they? One of the great paradoxes of recent economic history is that ‘communist China’ actually seems to have become better at running a capitalist economy than the US or the European Union. Exhibit A in support of this thesis is the various responses to the ‘global financial crisis’. In reality, of course, it was no such thing: China’s highly effective stimulus package ensured that it sailed placidly through a crisis that profoundly affected many Western economies. Or so it seemed.

It is now becoming clearer that—as in Australia, perhaps—not all of the crisis bail-out money was wisely used in China either. In China’s case the scale of the problems, and the difficulty of managing them without undermining the all important economic growth that maintains social stability and gives a veneer of legitimacy to the CCP, presents a formidable policy agenda. The great unknown is whether China has the institutions, relationships and established practices in place to pull this off.

One key challenge is reining the so-called ‘shadow banking system’. The potential dangers of this amalgam of private equity funds, hedge funds, insurance companies and the off-balance sheet activities of investment banks were dramatically revealed in the GFC when ‘structured investment vehicles’ went bust in spectacular fashion, bringing the American economy to its knees in the process.

Similar entities have emerged in China, with potentially equally catastrophic implications. It is now estimated that up to a third of China’s formidable savings are invested in ‘wealth management products’, rather than state-owned banks with their far less attractive interest rates. But the old adage about risk and return is being confirmed once more as new investment products and schemes go bust in China. The key questions for China’s policymakers are how should they respond in the short-term and does this presage a more fundamental, long-term ‘structural’ crisis?

Dealing with so-called moral hazard, especially at the level of the individual, is an especially thorny problem in China because the communist government is supposed to have an intimate relationship with the masses. Should governments protect individuals from the consequences of their own foolish actions? Naïve proto-capitalists with little experience of exotic financial instruments might be forgiven for expecting government assistance in the event of collapses in an inadequately regulated financial sector.

But a distinctive feature of China’s problems is a division of labour between the People’s Bank of China (the central bank), and the China Banking Regulatory Commission, which also claims some authority in overseeing the banking sector in particular. Similar divisions and misplaced expectations about regulatory responsibility were at the heart of Britain’s financial crisis, which culminated in the sort of run on a bank that many thought had been consigned to history. Worryingly, China’s domestic debt levels have grown to more than 200% of GDP since 2008—the same sorts of levels that prevailed in the US and Europe before they crashed.

Bank runs are not a good look even in economies that have populations seemingly inured to the vicissitudes of capitalism and its inevitable crises. In democracies, they can always turf out the incompetents in the hope, if not the expectation, that their successors will not repeat the same mistakes. No such option exists in China, of course, and the stakes are significantly higher as a consequence.

All of this matters to Australia not simply because of the long-term geo-political and geo-economic consequences of a wobbly China, but because in the short-term the shadow banking system has been one of the principal conduits of funding to China’s real estate sector. Local governments across China have become evermore reliant on the revenue generated by land sales to property developers, who are in turn, some of the shadow banking sector’s most important clients.

Much of the iron ore from the Pilbra ends up in the endless apartment blocks that dot the skyline of Chinese cities. An alarmingly high number of these blocks are unoccupied, however. The chairman of the Bank of China, a major commercial lender, described the situation as ‘fundamentally a Ponzi scheme’. In other words, it works well until it doesn’t. The implications for China of a rapidly collapsing real estate bubble are frankly scary, and put Australia’s potential problems in perspective.

The authority and competence of the central government would inevitably be sorely tested if China experiences the sort of crisis the US experienced as a consequence of the actions of its shadow banking sector. The rapid resolution of the threatened collapse of China Credit Trust, a major shadow lender, suggests that the authorities will—as Europe’s chief central banker Mario Draghi put it—do whatever it takes to ensure stability.

Daunting as these intersecting economic and political problems are, the historical record so far suggests China’s state capitalists may defy the sceptics. After all, they have overseen an historically unprecedented process of economic development that has been quite breathtakingly successful thus far. China’s notionally communist leaders may yet prove to be better at managing capitalism’s excesses than their counterparts in the West.